In Chapter 2, we discussed the measurement of several economic variables used to gauge the economy's health.
The measurement of economic performance is a prelude to the main objective of macroeconomics: to understand how the economy works. Understanding how the economy works requires a shift from economic measurement to economic analysis.
In Part 2 of this book, which begins with this chapter, we have two main goals. The first is to analyze the factors that affect the longer-term performance of the economy, including the rate of economic growth, productivity and living standards, the long-run levels of employment and unemployment, saving and capital formation, and the rate of inflation, among others.
The second goal is to develop a theoretical model of the macroeconomy that you can use to analyze the economic issues covered in this book and others that you may encounter in the future. As outlined in Chapter 1, our model is based on the assumption that individuals, firms, and the government interact in three aggregate markets: the labor market (covered in this chapter), the goods market (Chapter 4), and the asset market (Chapter 7). In developing and using this model in Part 2, we generally assume that the economy is at full employment, with quantities supplied and demanded being equal in the three major markets. As we are focusing on the long-term behavior of the economy, this assumption is a reasonable one. In Part 3, in which we explore business cycles, we allow for the possibility that quantities supplied and demanded may not be equal in the short run.
In this chapter, we begin the discussion of how the economy works with what is perhaps the most fundamental determinant of economic well-being in a society: the economy's productive capacity. Everything else being equal, the greater the quantity of goods and services an economy can produce, the more people will be able to consume in the present and the more they will be able to save and invest for the future.
In the first section of the chapter, we show that the amount of output an economy produces depends on two factors: (1) the quantities of inputs (such as labor, capital, and raw materials) utilized in the production process and (2) the productivity of the inputs—that is, the effectiveness with which they are used. As discussed in Chapter 1, an economy's productivity is basic to determining living standards. In this chapter, we show how productivity affects people's incomes by helping to determine how many workers are employed and how much they receive in wages.
Learning Objectives
3.1 Discuss production function properties and changes.
3.2 Discuss factors that affect the demand for labor.
3.3 Discuss factors that affect the supply of labor.
3.4 Identify factors that affect labor market equilibrium.
3.5 Explain how the unemployment rate is measured and describe changes in employment status.
3.6 Explain the significance of Okun’s law.
Of the various inputs to production, the most important (as measured by share of total cost) is labor. For this reason, we spend most of the chapter analyzing the labor market, using the tools of supply and demand. We first consider the factors that affect the quantity of labor demanded by employers and supplied by workers and then look at the forces that bring the labor market into equilibrium. Equilibrium in the labor market determines wages and employment; in turn, the level of employment, together with the quantities of other inputs (such as capital) and the level of productivity, determines how much output an economy produces.
Our basic model of the labor market rests on the assumption that the quantities of labor supplied and demanded are equal so that all labor resources are fully utilized. In reality, however, there are always some unemployed workers. In the latter part of the chapter, we introduce unemployment and look at the relationship between the unemployment rate and the amount of output produced in the economy.
3.1